Are You Buying Low and Selling High?

In last Friday’s article, I talked about how capital gets distributed, and to whom, when a start-up is acquired.

Based on all the emails our subscribers sent us requesting more information, it seems I touched on a hot topic!

One of your recurring questions was about a company’s valuation – i.e., the value of the start-up at the time of your investment — and the role it plays in earning a good return.

This topic plays into something we’ll come back to often and gradually expand upon: understanding how to “buy low and sell high” with equity crowdfunding investments.

To get the ball rolling, we thought we’d start with the basics: what you’ll see below is a brief excerpt about valuation from our 10 Crowdfunding Commandments report. You can find the whole report in the Resources section of Crowdability’s website.

• Capital Appreciation - This happens if the business is acquired by another company, or if the business becomes so large and successful that it goes public in an initial public offering (an IPO) and starts to trade on a stock exchange like the Nasdaq.

• Dividends/Distributions - This happens if a company becomes profitable, and decides it doesn’t need all its profits to grow the company’s operations. At that point, it can start to return money to shareholders.

If you’re investing in technology start-ups that are trying to get as big as they can, as fast they can, they’ll likely use any revenues or profits to further grow the company. In other words, it’s more likely that you’ll be rewarded via capital appreciation than via dividends.

As you evaluate an investment opportunity, here are some important numbers to look at:

• What is the company worth today, according to the entrepreneur? In other words, what is the company’s valuation?

• How much capital is the company raising?

• If the company is acquired in the future, what ballpark price, or range of prices, is most likely?

• What percentage of the company will you own if/when it sells?

What’s it Worth?

For example, let’s say you’re considering an investment in a financial news website, similar to thestreet.com or Yahoo Finance. You think it’s better than the competition, you respect the team, and you believe it’s targeting a big, growing market.

Let’s say that the company has been around long enough to make some progress. They raised money from friends and family 18 months ago to build their team and launch a website. Now people seem to like it: many people visit the site every month, advertisers are paying to be there, and traffic is growing quickly because of a recent partnership with a bigger company.

The entrepreneur has set the value of the company at $800,000, and he is raising $200,000 in new capital. $800,000 is what’s called the “pre-money” valuation, because it’s the value of the company PRE, or before, they raise the $200,000.

The “post-money” valuation is the valuation of the company POST, or after, the cash infusion. In this case, the post-money would be $1 million, so you can see that company’s value increases by exactly the amount of cash that’s invested.

To make the math simple: If you personally invested $100,000, your share of the business (which is based on a “post-money” valuation) would be 10%. That’s $100,000 divided by $1 million.

Your Return

Now let’s say a few years go by and the company is doing very well. It used the $200,000 to hire salespeople and strengthen its website. It reached profitability and didn’t need other outside investment. A bigger company decides it wants to acquire it, and is willing to pay $5 million.

In this case, you would potentially realize a profit of 5 times your initial investment (before taxes and closing costs, etc.). Since you invested $100,000 and own 10% of the company, you would receive 10% of the $5 million acquisition price, or $500,000.

The question then becomes one of probability. In other words, how likely is it that a bigger company will come along and acquire the business you’re thinking of investing in? If the company is in a fast-growing sector, the odds of success are increased. Or maybe you’ve read about similar companies that have already been acquired. If large companies are buying smaller companies in the sector, that can be a good sign!

Art & Science

The above example highlights the basic math of determining the post-money valuation of a private company.

It’s important to keep in mind, however, that pre-money valuations tend to be more art than science. For example, while $800,000 might in some cases be a “fair” valuation, in other cases, $500,000 might be the right number, or $5 million.

You’ll have to use your best judgment to determine, given the valuation the entrepreneur has set, if the ownership stake you’ll be acquiring is adequate to provide you with a reasonable return if/when the company is acquired down the road.

As noted above, we’ll continue to revisit this topic in coming articles. In the meantime, we hope today’s post provided a good foundation to build on!